Tag Archives: Eurozone

For those of you who are a bit confused about what exactly is happening, or not happening, in Europe.

This post is for Americans who know nothing about the debt crisis in Europe. I am going to try to provide a big picture framework and draw attention to what I think should matter most to Americans. If you have expertise in this topic I hope you’ll help me improve my analysis. This topic is somewhat new for me.

I think of the European debt crisis in three layers:

national debt crises in several European countries;

a structural crisis of the Eurozone; and

potential banking crises in Europe and the U.S.

Most current press coverage is about the middle layer: can European leaders prevent the Eurozone from dissolving? The top and bottom layers deserve more attention than they are receiving. American policymakers need to think hard about and plan for the possibility that a really bad outcome in Europe leads to another American banking crisis.

Why ultimately should the US care? (As a background, the author of this post, Keith Hennessey, is the former Assistant to the U.S. President for Economic Policy and Director of the U.S. National Economic Council under ‘W.’ Hardly a liberal.)

The bottom layer, the interaction between European sovereign governments and banks in Europe and the U.S., is not getting nearly enough policy or press attention, and it worries me a lot. From an American self-interest perspective, the direct economic effects of a Eurozone collapse on U.S. exports would be very bad and could easily tip the U.S. into recession. But the effects of a collapsed Eurozone or an Italian default on European banks, and the indirect effects that are passed through to American banks, could be far, far, worse. Think 2008 financial crisis worse. The worst case scenarios for Europe appear to pose a low probability, high consequence threat of another horrific U.S. banking crisis. This is why American policymakers should care deeply about Europe — because if the Europeans screw it up badly, it could do serious damage to the American economy, transmitted through still flawed and vulnerable banking systems.

Nouriel Roubini, a professor from NYU most famous for predicting the housing collapse, sees more disaster ahead. Writing in the Financial Times, Roubini, nicknamed Dr. Doom for predicting disaster in the housing market when everyone else was riding high, spells out the problem facing Europe, and thus the rest of the world.

Italy is too-big-to-fail, but also too-big-to bail. Even if it restructured its debt (2.58 trillion USD), it would still suffer from “a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.” To resolve those problems Italy may “need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.”

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

Roubini continues:

So Italy and other illiquid, but solvent, sovereigns need a “big bazooka” to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.

He explains that Eurobonds are out of the question due to German politics – they’ve bailed out enough people, they say (rightly) – and the ECB is prevented from doing so: “as unlimited support of these countries would be obviously illegal and against the treaty no-bailout clause.” Roubini also dismisses other discussed options as ineffective or unrealistic.

The austerity necessary to pay down the debt and save the credit ratings, he argues, will make the recession worse: “Raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. ”

Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness. That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies.

If you cannot devalue, grow, or deflate to a real depreciation, you must abandon the Euro. The eurozone could survive Greece or Portugal doing so, but not Italy (or Spain). That would effectively break-up the eurozone. That “slow-motion train wreck is now increasingly likely.”

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster.

There are even odds that this will happen. Berlusconi has resigned as prime minister, but that will only calm the markets for so long. The structural problem of their debt remains. As does the threat of the collapse of the euro. They will continue regardless of who hosts the next bunga bunga party.

The BBC has a great primer on the global economy, especially the Eurozone. Through a series of 60-second video clips, they explain the IMF, how banks go bust, quantitative easing, and the role of the ECB. They also have several articles that tackle those and similar subjects in both the Eurozone and the world economy. Very straightforward, nonpartisan information, and recommended for those who are a bit confused when reading today’s headlines.

Not so in the case of the euro. The euro zone is a hybrid: a single currency with 17 national fiscal and economic policies. It has no common treasury, no tax-raising powers, no joint bonds and no central bank acting as lender of last resort. In good times, this did not matter. But in the worst financial crisis in decades, the flaws are glaring. Even Mr Berlusconi cruelly described the euro as “a strange currency that has convinced nobody”.

Countries cannot quit the euro without extreme economic pain, but nor is it easy to fix. Vetoes may be needed to maintain democratic consent, even if they make for poor crisis management. A blockage in one country endangers all. The markets are testing the ambiguities to destruction. Vague promises to “do whatever it takes” to save the euro are not enough. Will the ECB deploy its full resources to stop the crisis? How much intrusion into national policies are Greece and Italy ready to accept? How far is Germany willing to extend its credit? Will the euro zone’s states hang together or hang separately?

These are big questions, affecting the nature of the state, sovereignty and democracy. Mr Papandreou may have messed up his tactics, but he was right on one point. The changes needed to save the euro are so profound in nature that, sooner or later, they must have the explicit consent of the people—or they will fail.

There is a Keynesian argument to be made against austerity: it will lead to a contraction that will further the deficit problem. Not all economists believe that, but let us for the sake of argument say that it’s true. Are these protestors really arguing this, or are they fighting like hell to keep their (unearned) entitlements? If there were to be a Keynesian stimulus now, would these same protestors accept spending cuts in the future? When the Socialist Party is the party of fiscal responsibility, you know a nation is in trouble.

Private holders of Greek debt may need to accept losses of up to 60 percent on their investments if Greece’s debt mountain is to be made more sustainable in the long-term, a downbeat analysis by the EU and IMF showed on Friday.

Euro zone finance ministers threw Greece a lifeline on Friday by agreeing to approve an 8 billion euro loan tranche that Athens needs next month to pay its bills.

But the European Commission, European Central Bank and International Monetary Fund — the so-called troika — issued a gloomy report on Greece’s ability to pay its debts.

Among three scenarios it examined, the only one that would reduce Greece’s debt pile to 110 percent of GDP — a level still regarded as high — was one in which private bond holders agreed to a 60 percent haircut.

The bond holders are required to sacrifice, but not the Greeks – who collectively act like spoiled teenagers demanding to borrow the car without having first done the dishes.

Let the Greeks default and leave the Eurozone to return to the drachma. Their bondholders will take their losses. The drachma will be allowed to depreciate relative to the Euro which will spur the Greek economy. They’ll be unable to borrow foreign money, and so will be forced into austerity. If they try to print their way out, only the Greeks will be hurt, not all of Europe. They will have to live as responsible adults, not spoiled teenagers. (The difference is that adults pay for their lunches. Teenagers believe they are free.) The rest of the Eurozone can worry about their balance sheets and the health of Spain and Italy – “too big to bail, too big to fail.” The Euro would be strengthened and its interest rates lowered. It would also be more respected as a currency and a stronger rival to the USD as the world’s reserve currency.

A few weeks ago, we got a glimpse of Germany’s nightmare scenario: Markets began focusing on Italy and its debt became expensive. The European Central Bank intervened, buying Italian bonds, which lowered rates at which Rome could borrow. As soon as the situation stabilized, Italy’s prime minister, Silvio Berlusconi, began watering down his commitments to enact economic reforms.

With such leadership, the future looks bleak for Europe.

Europe needs a crisis agenda to get out of its bind, but beyond that it needs a growth agenda, which involves radical reform. The fact is that Western economies — with high wages, generous middle-class and political subsidies, and complex regulations and taxes — have become sclerotic. Now they face pressures from three fronts: demography (an aging population), technology (which has allowed companies to do much more with fewer people) and globalization (which has allowed manufacturing and services to locate across the world). If Europe — and, for that matter, the United States — cannot adjust to this new landscape, it might escape this storm only to enter another.